Chapter 2

Answers to Review Questions

1.

(a) Insurance can be defined as the pooling of fortuitous losses by transfer of such
risks to insurers, who agree to indemnify insured for such losses, to provide other
pecuniary benefits on their occurrence, or to render services connected with the risk.
(b) Pooling of losses; payment of fortuitous losses; risk transfer; and indemnification.

2.

The law of large numbers states that the greater the number of
exposures, the more closely the actual results will approach the
probable results expected from an infinite number of exposures. As
the number of exposures increases, the relative variation of actual
loss from expected loss will decline. Thus, the insurer can predict
future losses with a greater degree of accuracy as the number of
exposures increases. This is important, since an actuary must
charge a premium that is adequate for paying all losses and
expenses during the policy period. The lower the degree of
objective risk, the more confidence an insurer has that the actual
premium charged will be sufficient to pay all claims and expenses
and leave a margin for profit.

3.

There are several requirements of an ideally insurable risk:

(a) There must be a large number of exposure units.
(b) The loss must be accidental and unintentional.
(c) The loss must be determinable and measurable.
(d) The loss should not be catastrophic.
(e) The chance of loss must be calculable.
(f) The premium must be economically feasible.

4.

Insurers can deal with the problem of a catastrophe loss by (1)

reinsurance, (2) avoiding the concentration of risk by dispersing
coverage over a large geographical area, and (3) use of certain
financial instruments in the capital markets, such as catastrophe
bonds.

5.

These risks are generally uninsurable for several reasons. First,

many of these risks are speculative risks, which are difficult to
insure privately. Second, the potential for a catastrophic loss is
great; this is particularly true for political risks, such as the risk of
war. Finally, calculation of the correct premium may be difficult
because the chance of loss cannot be accurately estimated.

6.

(a) Adverse selection is the tendency of persons with a higher-thanaverage chance of loss to seek insurance at standard (average)
rates, which, if not controlled by underwriting, results in higher than
expected loss levels.
(b) Adverse selection can be controlled by careful underwriting, by
charging higher premiums to substandard applicants for insurance,
and by certain policy provisions.

7.

(a) The benefit of insurance to the society are:

Indemnification for loss;
Reduction of worry and fear

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 Source of investment funds

Loss prevention
Enhancement of credit
(b) The costs of insurance to society are:
Cost of doing business
Fraudulent claim
Inflated claim
8.

Insurance differs from hedging. An insurance transaction usually

involves the transfer of risks that are insurable, since the
requirements of an insurable risk can generally be met. Hedging is a
technique for handling risks that are typically uninsurable, such as
protection against a substantial decline in the price of commodities.
A second difference is that insurance may reduce objective risk
because of application of the law of large numbers. In contrast,
hedging typically involves only risk transfer, not risk reduction.

9.

Casualty insurance is a broad field of insurance that covers whatever is not covered
by fire, marine and liability insurance; casualty lines include auto, liability, burglary
and theft, workers compensation and health insurance.

10.

(a) Social insurance programs are government insurance programs

with certain characteristics. The programs are enacted into law to
deal with social and economic problems. The programs generally
are compulsory and financed by contributions from covered
employers and employees; benefits are paid from specifically
earmarked funds; benefits are skewed or weighted in favor of lower
income groups; benefit amounts generally are related to the
covered individuals earnings; and eligibility requirements and
benefit rights are prescribed by statute.
(b) Major social insurance programs are the following:
Old-age, survivors, and disability insurance (Social Security)
Medicare
Unemployment insurance
Workers compensation
Compulsory temporary disability insurance
Railroad Retirement Act

Answers to Application Questions

1.

(i) Risk of fire

(a) Large number of exposure units. This is generally met,
since there are millions of homes that are insured.
(b) Accidental and unintentional loss. This requirement is
generally met, since most insureds do not deliberately start a
fire.
(c) Determinable and measurable loss. A fire loss can be
determined and measured. In case of disagreement, a
property insurance policy has a provision for resolving
disputes.
(d) No catastrophic loss. This requirement is met, since most
homes do not burn at the same time.
(e) Calculable chance of loss. Insurers can estimate within
ranges the probability of a fire loss.

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(f) Economically feasible premium. For most insureds, this

requirement is fulfilled.
(ii) Risk of war
(a) Large number of exposure units. This requirement is not
fulfilled. Based on the law of large numbers, it is difficult to
estimate accurately the number of wars that will occur.
(b) Accidental and unintentional loss. This requirement is not
met. Most wars are not accidental, but intentional.
(c) Determinable and measurable loss. Although a war loss
can be determined, the measurement of loss would be
difficult.
(d) No catastrophic loss. This requirement is not fulfilled,
since large numbers of exposure units would simultaneously
incur losses.
(e) Calculable chance of loss. This requirement cannot be
easily met.
(f) Economically feasible premium. Because of the
catastrophic potential of war, the premiums would not be
economically feasible.
2.

(a)

(1) Indemnification means that insureds are restored to their

former financial position after a loss occurs, either partly or
wholly. As a result, individuals and families can maintain their
economic security and are less likely to apply for public
assistance or welfare, or seek financial assistance from
relatives and friends.
(2) Insurance makes a borrower a better credit risk because it
guarantees the value of the borrowers collateral, or gives
greater assurance that the loan will be repaid. For example,
life insurance can be used to pay off a bank loan if the
creditor dies prematurely, and so makes the creditor a better
credit risk.
(3) Premiums are collected in advance, and funds not needed
to pay immediate losses and expenses can be loaned to
business firms. These funds typically are invested in capital
goods, such as housing developments, shopping centers, new
plants, and machinery and equipment. Since the stock of
capital goods is increased, economic growth and full
employment are promoted. In addition, since the supply of
loanable funds is increased, the cost of capital to business
firms is lower than it would be in the absence of insurance.
(b) The major social and economic costs of insurance are the
following:
Cost of doing business
Fraudulent claims
Inflated claims
3.

(a) Ideal requirements of an insurable risk:

Large number of exposure units
Accidental and unintentional loss
Determinable and measurable loss
No catastrophe loss
Calculable chance of loss

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 Economically feasible premium

(b) The requirement of not having a catastrophe loss is not met
because large numbers of exposure units in a flood zone would be
incurring losses at the same time. Also, the requirement of an
economically feasible premium generally is not met. Without a
government backup, premiums for flood insurance in major flood
zones generally would be unaffordable for many insureds.
4.
(a) Life insurance can provide the needed funds for a college
education.
(b) Auto liability insurance will protect the parents if Danielle
negligently injures someone while driving a family car.
(c) An individual or group disability income policy will provide
periodic income payments if Jacob becomes totally disabled.
(d) A homeowners policy will provide the desired protection.
Windstorm and hurricanes are covered perils.
(e) A commercial general liability insurance policy will cover Nathan
if a customer is injured in his store.

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